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Why do I use the pre tax cost of debt to calculate the tax shield on a subsidised loan? For example
Tax shield – calculate tax pa (using subsidised rate), then calculate tax saving pa on this answer, then use the company’s pre-tax cost of debt to calculate the AF to find out the tax shield. Why not use the subsidised rate to find AF?
I could just take this as a given, but if I understand why I’m doing it I’m more likely to remember.
Is it generally working out what we are saving from the subsidy ie as opposed to having to pay the full value of loan at the company rate rather than the cheaper money available from someone else who will benefit from our business – quite often a government in a country encouraging investment?
Thanks
By AF do you mean the annuity factor?
If so, then the interest rate used to get the annuity factor should be the rate applicable for the level of risk involved.
Here there are two arguments – one is to assume that the tax benefit is risk free and therefore to use the risk free rate.
The other argument is to accept that debt does carry some risk (and so therefore does the tax benefit) and to therefore use the pre-tax cost of debt. The examiner usually goes for the second alternative (but gives full marks to either).The last paragraph of your answer is a different issue. There is always the benefit of the tax relief, but if there is a subsidised loan then there is the additional benefit of being able to borrow at a cheap rate (for reasons such as the one you mention – government wanting to encourage investment).
Thanks – I did mean annuity factor. I think that helps. Stating assumptions gains more marks, so being able to justify them adds to that I guess – and helps to understand.
Is this benefit/ saving of interest on subsidy loan taxable? In Fubuki (Dec 10) this benefit is taxable. Co. can borrow at 7.5% but gov offered a subsidised loan on 80% of investment at 5.5%. tax is 25%
In the ans the benefit is: (14488*80%) x .02x 75%x Anniuty factor.It is not that the benefit itself is taxable, but because you are paying less interest you do not get the tax saving on the full interest (i.e. you lose the tax saving on the benefit)
I didn’t get your point.. If it is a loss of tax saving then why is it added to the benefit in the answer, it should have been subtracted then.
If I understand this correctly, Toobalvi – please correct me if I am wrong, John Moffat.
Breaking down the individual components of the saving to the company
14488 * 80% – is the amount of the loan to be subsidised
.02 or 2% is the amount of the subsidy
75% is the amount the company saves (adjusted for tax)
Annuity factor discounts the sum to net present valueSo basically you are saving 100% of 2% interest due to the subsidy(positive value), but you can’t reclaim 25% of 2% in tax on this sum(negative value) – so the net effect is that the company saves 100%-25%=75% which is a positive figure – a benefit to the company and a positive adjustment to APV.
This is a tough paper – I’m on my first resit (35% first time). Remembering is easier if it is understandable where information comes from (a downfall in my first sitting, a challenge this time). There is so much to understand, I hope you are enjoying the subject – it will make learning it so much easier. I wish you every good luck in December 🙂
Dear Tutor,
In the answer of BPP book, Gordonbear example, the benefit of being able to pay a lower interest rate is not adjusted for tax.
Please explain.
Thanks.I am sorry, but I do not work for BPP and I do not have their book – so I cannot comment on what they have done.
In principle they should have adjusted for the tax (otherwise we would be accounting for a tax benefit that they did not get) but without seeing the question and their answer it is not possible for me to explain what they have done (or be able to say they have made a mistake).
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